When it comes to setting a commercial loan’s maturity and amortization, banks tend to rely on tradition. Given tighter spreads and more competitive lending, it is more important than ever to have a working knowledge of how maturity, amortization, risk, loan structure and pricing interplay to produce the highest risk-adjusted return. As we have covered in the past balloon structures inject liquidity risk into the loan equation and often hurt profitability. Since loan risk usually elevates in year 2 and peaks between year 5 and 7, creating a liquidity (refinancing) event prior to that is often counterproductive. While balancing all the loan factors used to be more art than a science, with greater availability of lending data, we now can get more granular to come up with an optimized structure based on maturity and amortization. Today, we look at 6 structures and highlight one in particular that stand out as being the best risk profile for a bank.
Maturity vs. Amortization
Every industry, borrower/project and economic cycle is different so there is no hard rule of thumb for when to structure a maturity and amortization. While the borrower has large influence on the loan’s structure, often the bank can take a leadership role in setting terms. Once you get past year 5, usually the incremental risk drops and then stabilizes. As a result, risk-adjusted profit increases with each additional year which means, all things being equal, a longer loan with longer amortization is usually more profitable. However, the offset to that is while incremental risk decreases and profitability increases, cumulative risk increases with each year principal is at risk. This brings up with question – how do you balance the risk trade-off between maturity and amortization? Increasing amortization helps increase debt service coverage which lowers default risk. Counterbalancing that positive aspect, longer amortization also means more principal at risk in any given year so the loss given default tends to increase. Because of these two factors, there is a balance act with every loan, which is why a risk-adjusted profitability model is so important.
Go To The Data
To answer the question, we go to the data at look at the performance of more than 2,100 hundred commercial real estate loans. We then modeled a typical Orlando, FL, industrial loan with 1.3x debt service coverage, 70% loan to value and 85% occupancy. We analyzed a series of maturities from 3 years to 15 years and then looked at 7,10,15 and 25-year amortization. While multifamily loans behave a little differently, we point out that the outcome would have been the same for other loan types and other performing credit profiles. We then looked at the one-year probability of default and the total loss given default under a non-recessionary scenario. By looking at what loans have performed the best based on structure, surprisingly one structure emerged as having the best profile.
The 10Y / 10Y
The 10-year fully amortizing loan has the advantage of being in the sweet spot of profit and risk. Once you get past a balloon structure, matching amortization with maturity has some nice advantages. At the 10-year mark, you have one of the lowest annual probabilities of default, while also limiting the loss given default.
We will quickly note that the difference isn’t that significant so ultimately the borrower’s economic outlook, objectives and dreams should drive the structure. More importantly, one of the takeaways from today’s research is that contrary to convention, bankers shouldn’t assume the risk profile doesn’t really change by extending maturity and amortization out. As can be seen below, the risk difference between a 10Y / 10Y loan and a 15Y / 25Y loan is slight. As a result, increasing pricing for a longer maturity or amortizing loan can actually help lower the net risk of a longer term loan provided the bank can get it.
Don’t assume all structures are the same. Increasing pricing for short balloon loans, and extending maturity and amortization out (while keeping pricing the same or higher) are a couple profitable ideas that can help increase lending profitability.
Submitted by Chris Nichols on October 27, 2015